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FDI-Related Policies in Hungary 1990-2001
Introduction
The aim of this paper is to provide fuel for discussions on foreign direct investments, and their
activity in Hungary. The paper tries to pick up the most relevant issues of discussions and
provides some necessary background knowledge on these. It is very difficult to remain neutral
concerning foreign investments and foreign ownership. The author confesses to being an
advocate of foreign investment, but also admits that there are considerable drawbacks,
negative tendencies that deserve attention. This is exactly the reason why it makes sense to
openly discuss issues of foreign investments.
Some Facts about Hungary

Inhabitants: 10 million, 93 % Hungarians, 5 % Roma, 2 % other nationalities.

GDP per capita: 6000 USD, average monthly gross salary USD 330.

Education: (Of persons employed) 17,2%: higher education; 65,3%: secondary
education; 16,7 %: primary education; 0,7 %: no completed education.
Brief Overview of Macroeconomic Context
Main macroeconomic indicators
The main macroeconomic indicators are presented in Table 1. As can be seen, Hungary
underwent a rather deep transitional recession period during 1991-1995. At its deepest level,
GDP reached less than 85 % of the last pre-transition years’ level. The recovery started rather
slowly and started to accelerate in 1998. All in all, the Hungarian economy reached the pretransition performance level after 10 years. This is still much better (a shorter recession
period), than in many other transition economies of Central Europe. Other indicators of Table
1 such as inflation, unemployment, per capita real income, budget and BOP deficits also
indicate the magnitude of decline.
Table 1. Various macroeconomic indicators of Hungary
1991
1993
1995
1997
1998
1999
2000
GDP growth (1990=100)
88,1
84,9
88,6
93,9
98,5
102,6
108,0
Inflation %
35,0
22,5
28,2
18,3
11,4
10,0
9,4
Unemployment %
7,5
12,3
10,4
7,8
7,0
6,3
5,6
Investments (1990=100)
87,7
88,4
94,2
107,5
121,2
127,6
137,2
Exports (1990=100)
95,1
83,4
105,3
143,2
175,3
203,3
247,5
FDI stock*
1459
5269
10869
14937
16872
18523
20323
Trade acc. deficit (% GDP)
-4,1
-9,4
-5,7
-4,7
-5,8
-6,3
-8,5
Current a. deficit (% GDP)
0,8
-9,1
-5,5
-3,3
-2,0
-4,4
-3,2
Budget balance (% of GDP) 0,0
- 6,0
- 4,6
-4,0
-4,8
-3,7
-3,4
Per capita
(1990=100)
real
income 98,4
90,2
88,6
89,4
92,7
93,5
..
*Cumulated value of FDI payments through the banking system
Source: CSO, National Bank of Hungary
Other measures also highlight some of the important features of structural change in the
Hungarian economy. Transforming from central planning to market economy required the
exchange of economic activities developed under the logic and rule of the former to ones
responding to demands of the later. This deep structural change is shown in the rather fierce
growth of investments, FDI and exports. Consequently, the sectoral structure of the economy
changed to the one presented in Annex 1. The sectors “electrical and optical equipment” and
“transport equipment” increased their shares by several times, meanwhile sectors traditionally
important for centrally planned economies, like heavy industries, lost share.
Investment Flows
The main driving force of economic restructuring in Hungary was FDI. Hungarian
governments and firms gathered experience with foreign firms through various co-operation
links. Licence transfers, creation of joint ventures, regular supplier contacts were developed as
early as in the 1970’s. This was an important achievement of the Hungarian economic reform
movement. Also, foreign firms had some knowledge and experience in Hungary. Thus, the
intensification of business contacts was a rather natural phenomenon after the transition
process started. FDI was strongly promoted through various channels, which will be discussed
later on. Consequently, Hungary became one of the most popular investment targets in
Central and Eastern Europe. Table 3 contains the most important FDI figures.
Table 3. Selected indicators of foreign direct investments in Hungary (US$mn)
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Inward FDI
1459 1471 2339 1147 4453 1983 2085 1935 1651 1800
Privatization FDI
435
492
1163 103
3370 618
1451 485
295
0
% share of privatization 29,8
in total FDI
33,4
49,7
9,0
75,7
31,2
69,6
25,1
17,9
0
% share of FDI in total 79,6
privatization revenue
61,0
48,2
8,9
86,9
52,1
78,1
67,9
..
0
% share of foreign ..
firms in exports
..
..
54
58
69
75
77
80
Outward FDI
..
..
..
43
0
431
481
249
..
532
Source: Hungarian National Bank, State Asset Holding Plc.
As it is seen from the figures of Table 3, the level of foreign investments varied basically
according to major privatization deals. There has been a rather steady level of investment to
the tune of some USD1-1.5bn annually. On top of this, privatization revenues pushed the level
of FDI higher, until the late 1990s. Then, the privatization process decelerated but FDI still
continued to flow in. Meanwhile, outward FDI also gained momentum. Part of this outward
FDI is relocation of foreign capacities to other transition economies and to China. Another
part is due to Hungarian capital owners’ investments in neighbouring countries. Relocation of
simple, unskilled labour-intensive activities and attraction of new, more sophisticated ones
marks a new epoch of FDI in Hungary.
Table 4 illustrates this shift. The figures here demonstrate the very deep penetration of foreign
capital in most economic sectors. The gap between earnings in foreign and Hungarian-owned
companies is rather wide in most branches. We interpret this gap as a sign of superior
performance. Foreign firms are able to cream the labour market. Above average figures in
manufacturing are due to very low wage levels of Hungarian firms. The narrower gaps in
engineering may be also due to some kind of a demonstration effect. Wages in the foreign
owned sector push up wages in domestic firms as well.
Table 4. % share of foreign companies in Hungarian economic sectors (1999)
in paid in in
in net sales gaps in per
capital
employment revenue
capita
earnings*
Agriculture, forestry, fishing
7,5
4,4
8,9
123,3
Mining and quarrying
34,4
23,9
38,2
111,4
Manufacturing
60,6
46,5
73,0
130,2
Food, beverages and tobacco
60,5
41,5
59,8
136,9
Textile
51,4
36,9
54,7
132,4
Rubber and plastic products
55,6
48,1
57,0
120,7
Machinery
53,8
43,5
55,0
113,1
Electrical machinery
72,1
66,1
88,9
111,8
Transport equipment
74,4
62,8
93,8
113,0
Electricity, gas, steam, water supply
28,1
34,6
51,7
112,1
Construction
29,1
9,8
21,3
196,8
Trade and repairs
43,3
22,6
42,7
189,6
Hotels and restaurants
28,0
19,4
26,8
152,7
Post and telecommunication
67,0
11,7
40,7
200,2
Total
37,9
27,4
50,0
160,7
*average earnings in foreign employment as a % of earnings in Hungarian employment
Source: CSO
As far as the countries of origin are concerned (Table 5), the bulk of the inward stock is
owned by firms of the European Union (EU). Non-EU owners also registered through their
European headquarters. Therefore, the Hungarian economy is rather strongly integrated in
European corporate networks. This phenomenon is completely in line with UNCTAD’s
description of the evolution of the triad in world economy, with fairly clearly separated
interest areas. Central Europe became the most important backyard of EU-based multinational
companies.
Table 5. Major countries of origin of inward FDI stock, 1999 (%)
Germany
Holland
Austria
USA
France
Italy
Belgium
27,3
22,5
12,1
8,8
6,2
2,7
2,5
Source: CSO
Figures in Table 6 demonstrate that although Hungary enjoyed a clear advantage in attracting
FDI to Central Europe, its dominance was lost by the late 1990s. It seems, that the amount of
capital available for investments in the region exceeds the amount Hungary can absorb.
Therefore, other more developed countries like the Czech Republic and Poland caught up with
Hungary.
Table 6. Selected Central and Eastern European Countries’ cumulated stock of FDI (USDmn, 2000)
Poland
Czech R.
Hungary Russia
Romania
Latvia
Estonia
38000
23300
21254
6426
4307
2106
20757
Source: WIIW database
Overview of Main Policy Trends
Hungary has a small open economy with a relatively small sales market. The number of
inhabitants is slightly over 10 million people. Moreover, the purchasing power of the
population is not very strong. The per capita GDP is about half of the EU average. But the
wealth of Hungarians is growing and purchasing power is increasing. The Hungarian
economy is an open economy with a share of exports of GDP of about half. This openness
increases the dependence of the country’s economic development on the features of its main
export markets in the EU.
As all other Soviet-oriented countries, Hungary had a centrally planned economic system.
This meant that instead of market mechanisms, it was the state that directed the activity of
firms. Socialist enterprises had no right to take independent decisions. They had to fulfill the
orders of the state authorities, the Planing Office and different Ministries. Foreign trade, and
relationships to foreign firms were also centrally controlled. The state control was not pushed
completely into the background even in the period of the Hungarian Economic Reform, when
Hungary experimented with the partial introduction of market forces in certain areas of the
economy. But the reform was not aimed at breaking with central control, thus, despite partial
success (for example slightly higher standard of living), it did not change the fundament of the
socialist economic system. This system proved to be inefficient and inferior to the market
economy, and was quickly replaced in the process of transition during the 1990s.
Economic transition in Hungary was rather quick and straightforward. There was a nationwide
consensus about the important milestones of the process. Everyone hoped that the
introduction of fully fledged market economic system will quickly turn around the economy,
and also the economic agents, companies. Though the process lasted perhaps longer, than it
was expected, still it was perhaps the quickest in Central and Eastern Europe. Today
Hungarian transition process is finished with a few exceptions. Transition process provided a
lot of opportunities for foreign investors. It was therefore Hungary where foreign capital
started to invest first in the region. Hungary received the most foreign investment until 1996
among countries in transition.
The first step in the transition was the liberalization of economic activity, foreign trade, prices,
foreign investment. For the small open economy this meant a sudden increase of deliveries
from developed countries that could provide superior quality of goods sometimes at lower
prices than domestic firms. Competition on domestic markets increased tremendously,
because of both increasing competitive imports, and increasing competition among local
suppliers. An important question and point of discussion is if a slower, more gradual
liberalization had been applied, would that have provided more time and some
temporary protection for local firms to grow and match foreign competitors? There is
empirical evidence that firms did not utilize such an opportunity in other transition economies.
They rather tried to pressure governments when they suspected the liberalization measures
were not credible. Strong competition on the other hand forced a number of Hungarian firms
to undertake major restructuring efforts in order to become more competitive.
Macroeconomic decline took shape on firm level as a massive wave of market exit. There
were different forms of market exit, for example formal bankruptcy and liquidation. The
Hungarian bankruptcy practice was exceptionally harsh in 1992-93: all debtors with
obligations past due by more than 90 days were legally forced to declare bankruptcy. Another,
less draconian form of market exit was even more important: downsizing, voluntary market
exit. The question can be put: What was the real impact of institutional changes? Were
these responsible for the economic decline, or they were rather necessary instruments of
economic restructuring? Evidence indicates that the decline of economic activity was a
system specific feature of transition rather, than the result of economic policy mistake, or false
institution building. But the speed of the process could have been slowed or the extent of
decline reduced through the use of other policy measures.
Massive downsizing, both in domestic and foreign markets necessarily led to a decline of
cooperation networks. Since former market links simply vanished, they had to be replaced, in
many cases through new contacts with multinational companies. The process was especially
strong in the small, open Hungarian economy. Liberalization of trade and economic activity
increased both domestic and foreign competition. In order to improve or regain competitive
strength, Hungarian firms soon started to replace suppliers of inferior quality and reliability.
This process started well before and independent of the bankruptcy wave of 1992.
Replacement of suppliers usually meant imports from developed economies. Improved
supplies substantially increased competitiveness for numerous Hungarian firms. Increased
competition had stimulating effects on the Hungarian economy. There were fundamental
changes in downstream direction as well. Hungarian firms’ sales markets altered from CMEA
sales to OECD, especially EU sales. The later strong economic growth however, was mainly
driven by greenfield investments of multinational companies. This also meant an increasing
role of foreign supplies in Hungarian production facilities. Hungary’s role in the
international labour division changed: it became an integrated part of global (mostly
European based) business.
Privatization and foreign investment
Privatization was also an important factor of corporate networks’ development. Hungarian
privatization policy favored sales to foreign strategic investors. The logic of this decision
was that foreign firms possessed the necessary technology, know-how, market share and
capital for the successful restructuring of Hungarian firms. The state also needed cash revenue
in order to finance growing trade balance deficits. Privatization primarily developed along
existing business links, speeding up the process and making matchmaking unnecessary.
Management of Hungarian firms was also provided an active role in shaping privatization
practice. This role was often used to support the sale of firms to previous foreign cooperating
partners. In these cases cooperation links were further strengthened even before the
privatization deal was concluded. Later, when the deal was accomplished and the Hungarian
firm became an affiliate, up- and downstream business links were reconsidered, and usually
substantially changed.
The spectacular success of Hungary in attracting FDI in the early 1990s was largely based on
FDI preference in privatization policy. Until 1994/1995, FDI was mostly conducted through
either the establishment of joint ventures, or privatization. Even some greenfield investments
started in the privatization process. For example, GM purchased a workshop from the
privatization agency to put up the Szentgotthárd Opel works.
Privatization related FDI meant in most cases an interest of investors in corporate assets like
facilities, workforce, products and brands, markets, even suppliers in some cases. The level of
local supplies is markedly higher in these cases than for greenfield investments. In food
industry, for example, the purchase of processing plants automatically meant access to local
agricultural output. In the case of food industry this fact is even a topic of discussions, since
agricultural producers feel exposed to superior economic power of foreign owned food
processing companies. This could have been avoided with farmers’ access to some
ownership rights in processing units. Since however, foreign owners usually gradually
increased their ownership share towards even exclusive rights, it is not very likely, that they
would have allow significant Hungarian ownership. Besides, many Hungarian manufacturers
were acquired by larger foreign companies during the 1990s, as in the dairy industry. On the
other hand, farmers’ fears of replacing their supplies with imports did not materialize. Still, a
more powerful competition policy might be applicable in certain markets where concentration
is very high (e.g. vegetable oils, sugar, tobacco, etc.).
The pioneering role of Hungary in developing policies of transition was also evidenced in
privatization. Hungary was the first economy to open up markets and sell firms in
services such as telecommunications, energy and water supply and banking and finance.
This required a redefinition of market regulation. New laws on telecommunication, on
concessions, on energy and water supply were passed with specific sales agreements for
buyers of the services firms. These contracts closely described the duties of the service
provider, and contained also guidelines and statements for the state for the further
development of the regulatory framework. When prices were kept under government control,
the principles of setting prices contained mechanisms of securing a certain level of profit for
the new owner’s activity. The contracted obligations of the state contradict sometimes with
other economic goals, such as anti inflation and welfare measures. The services privatization
is therefore frequently criticized.
Foreign investment policy
Government policy towards foreign investors has been one of the most favourable in Central
and Eastern Europe. The origins of the policy traced back a decade before transition started.
Inviting FDI to Hungary, mainly in the form of joint ventures was a major policy aim during
the 1980s and a fairly large number of JVs were established.
In the beginning of the nineties parallel with the liberalization of trade and economic activities
a generous legal framework was created for foreign investors. Establishment of joint
ventures with foreign capital participation was promoted by allowances of corporate income
tax. State subsidies were offered for large-scale investments in certain high technology
sectors (electronics, automotive, biotechnology, communications, etc.) and in tourism, for
investments in depressed regions with a requirement of certain amount of job creation, and for
increasing exports. Later, investment subsidies were expanded to domestic companies as well.
But conditions based on investment size and cost-sharing mean that it is mainly foreign firms
who are able to apply.. The scope of subsidized investments was further increased in the new
Hungarian development plan (the Széchenyi Plan). Among others, creation of industrial parks,
industrial clusters, incubator houses, establishment of R&D facilities, R&D cooperation
between industry, university and academia are supported. Cash subsidies must be
withdrawn soon, since they do not conform with EU regulations. The question emerges if
the attraction capacity will decline?
Another tool of investment promotion relevant to foreign companies and especially to
assemblers is the regulation of industrial free trade zones. Regulation was introduced in
1982 with the aim of attracting export-oriented, high technology FDI to Hungary and to
integrate these companies into the host economy. The risk of developing a dual economy
through regulation was recognized. It was decided therefore that there would be no
geographical restrictions for the zones. A company simply requires a license from the customs
and finance authorities. The zones are ex-territorial from the aspect of customs and excise
duties, VAT on machinery, foreign exchange and other legislation. This is an extremely
favorable regulation for assemblers which require only labour as a local input, as it enables
them to import high value equipment free of duty. They were also allowed to keep books and
accounts in foreign currencies that allowed them overcoming of currency exchange risks.
The two main forms of foreign investments were privatization deals, which can be regarded as
mergers or acquisitions, and greenfield investments. The logic of these types of investments
was different. Privatization purchases expressed an interest in existing assets, including
tangibles and non-tangibles (brands, skills, market share, R&D competencies, and supplier
networks). Privatization investments were and usually remained imbedded in the local
economy. On the other hand, most greenfield investments, especially assembly plants,
utilize only one local input (cheap labour) and show little attention to other valuable
local contributions. They can be hardly be moved out of this static position even through the
most attractive government incentives. They tend to remain isolated and provide little
impetus for local firms. The question here is rather obvious: what are the risks of a
strong but isolated assembly-based foreign sector? What are the chances of changing,
developing this status?
Balance of payments
Capital flows have a crucial role in shaping the national accounts. This became more evident
with the 1998 Mexican and Russian monetary crises, which also affected Hungarian balances.
In 1998 Hungary’s current account deficit deteriorated was USD2,3bn, almost 5 % of
GDP. The deterioration of the current account was rather unexpected, since after the
successful 1995 stabilization program GDP continuously grew, exports almost doubled, and
economic conditions improved. In the shadow of the international monetary crisis, serious
concerns were raised about the reasons for the deficit. Populist voices blamed foreign capital
that withdrew from Hungary and also repatriated substantial profits.
Some new features of the current account support this view. There was a huge increase in
repatriated incomes of foreign firms to USD1,5bn. This was only partially compensated by
inflows of FDI. Meanwhile outward FDI increased. FDI suddenly ceased to cover deficits
of the trade balance and capital balance although this was one of the main reasons of
preferring foreign investors in the privatization process.
Changing behavior pattern of FDIs from establishment and reorganization to full-scale
production meant reduced investments and generation of profits. It was a crucial task of
investment policy to stimulate reinvesting of profits. This proved to be much more
difficult than selling state assets or to ignite first investment decisions. This means that
new patterns of capital and income flows were to be expected in the longer run too.
In order to better understand what happened, we calculate the cumulative role of FDI related
capital and income flows. This is introduced in Chart 1. In fact, there was no fundamental
change of patterns in 1998. Inward FDI was still around USD2bn. This amount should
Chart 1. Capital flows associated
with FDI in Hungary (mn USD)
3000
2000
1000
0
-1000
1996 1997
1998 1999
inward FDI
incomes of FDI
b&t services
-2000
-3000
-4000
contain among others hidden profit transfers. In face, there was no sudden increase in services
payments towards abroad. The only change was in the increase of FDI-related income
transfers, though compared to the volume of the other two elements of the capital flows this
change was not dramatic.
This stress on this feature should, of course, not query the importance of growing profit
transfers and the impact on the current account. What is argued here is that the negative net
of FDI-related capital and income flows in 1998 was not a sudden and exceptional case.
Moreover we would like to emphasize that macroeconomic balances of modern, integrated in
the world economy economies usually rely on an interplay of capital and income flows of
domestic and foreign capital owners. Hungarian capital owners’ income flows from abroad
may have an important balancing effect. The 1998 deterioration of the current account was at
least as much a consequence of Hungarian capital owners’ practices as of foreign ones.
Still, growing volumes of inward and outward capital and income transfers pose a
potential threat for macroeconomic stability. Higher risks may require more advanced
tools of monetary policy. This means not only an appropriate FDI promotion system, but also
an adequate use of conventional monetary policy tools.
In order to demonstrate the relative importance of the three types of capital investments and
the related flows, we separated from the net figures the volumes of foreign capital owners’
transactions. Chart 2 shows interesting changes in the patterns of foreign investment. There
was a clear improving trend between 1996 and 1999. The large negative contribution of
changes in foreign held assets in 1996 improved very significantly in the subsequent years and
turned positive in 1999. Biggest changes were observed in the net portfolio and net bank
deposit situation. Outflows of deposits and income transfers in 1996 generated a negative
balance of USD2,6bn. It was the decline of portfolio stock, continuous portfolio profit
transfers and outflow of bank deposits that led to the accumulation of negative impacts in
1997. The behavior of portfolio investors and bank depositors changed in 1999 when the net
of both of these investment types was positive.
We do not want to go into detailed analysis of the reasons why the short-term investment
climate improved so much. Traditional policy tools like interest rate policy may have had a
role here, as well as economic growth and good business perspectives. What is important from
our point of view is the change in the behavior of short-term investors determined the
current account and the capital account to a much larger degree than foreign direct
Chart 2. Capital flows associated
with different types of investment
in Hungary (mn USD)
3000
2000
1000
0
-1000
-2000
1996
1997
1998
1999
net deposits
net portfolio
net FDI
-3000
-4000
-5000
investments. Changing patterns of FDI’s role can be seen from Chart 2 as well. Yet, the
relative importance of these changes was much smaller than in the case of the other two types
of investments. Moreover, the impact of FDI-related capital flows showed more clear trends
and proved to be less volatile posing less difficulties in macroeconomic calculations and
prognoses.
Trade Policy and WTO Membership
FDI affects the current account through the trade balance as well. The classical cycle was
reproduced in Hungary from this aspect. FDI required massive investments in tangible new
assets. The establishment of facilities or the modernization and reshaping of acquired ones
was carried out in one major investment effort between 1993-1997. The import needs of
investments increased machinery imports in this period, and deteriorated the trade balance,
since exports from the new facilities started to grow only after the investment projects were
finished. Exports started to increase at an astonishing pace after 1996. The major engines of
export growth were large greenfield investment projects in the industrial free trade
zones. Currently, firms in the free trade zones produce a strong positive balance of
trade. They are also major importers, assembling or transforming parts imported in intra-firm
trade. The export surplus roughly equals with their local added value (USD1-2bn annually).
The strong and growing deficit of the trade balance is a major headache. It is basically private
consumption that fuels the deficit. Experts criticize retail privatization and the rapid
expansion of large international retail chains for contributing to trade deficit through
increased imports of consumer goods. Local and foreign companies usually have to deliver
retail chains on the same conditions which are usually very tough and may not be fair. It is
therefore the inferior competitiveness that makes firms domestic and foreign alike drop
out of the sourcing mechanism of the large retail chains. From a number of aspects local
firms enjoy benefits of location advantages, though they are usually less powerful, their
brands are less well known as their multinational competitors.
Hungary used to be a member of the CAIRNS group for several years. This fact determined
the Hungarian standpoint at multilateral trade negotiations. Together with the CAIRNS group
Hungary was a supporter of trade liberalization especially in agriculture. Hungary also urged
the reform of export support systems (especially in EU’s Common Agricultural Policy, CAP).
Today, the Hungarian position became rather ambivalent. Struggling for EU accession
Hungary could not maintain its position with the CAIRNS group. Though medium term preaccession interest of the country remained the same, the situation may change completely
after the enlargement of EU. Hungary may become an important recipient of EU
agriculture funds. However, the ongoing reforms of the internal regulations of EU may also
include CAP, changing the mechanism altogether.
There are a number of other issues currently under discussion at WTO that also affect
Hungary, namely patents on drugs and protection for computer software. Meanwhile these
issues seem to be rather marginal, since ¾ of the Hungarian foreign trade is within free
trade zones, that are not influenced by the WTO agreement.
Restructuring and performance
FDI is expected to have strong spillover effects in the host economy. This means, that in the
long run their activity is expected to stimulate other firms as well, including domestic owned
companies. This paper describes two areas where beneficial spillover effects may be detected:
restructuring/productivity growth and R&D activities.
Domestic and foreign firms were compared several times. A comparison of state owned,
foreign- and domestic privatized firms’ downsizing activity found that downsizing was
similarly widespread. Foreign firms’ downsizing activity was usually quicker, but not
necessarily deeper, than other ownership groups. Closure and employment reduction was
paralleled or followed by investment. Restructuring meant both elimination of not-to-be-used
structures and creation of new ones. Other important areas of reorganization were human
resource development, marketing, and corporate organization-management. Streamlining of
the product range was usual, but it also meant the picking up of the production of new
products and entering new markets. Production technology was generally improved (at least
quality control and data communication).
Comparisons of corporate restructuring of firms in domestic- and foreign ownership revealed
the better conditions of foreign companies. There were two important factors readily
available for foreign companies and hardly accessible for domestic firms: markets and
capital. The analysis of corporate investment activity as the nucleus of restructuring clearly
showed that similar investment projects were launched in restructuring firms, but foreigners
were usually able to carry out their projects within 1-2 years. Hungarian companies were able
to carry out major investment projects only piecemeal and the whole restructuring project took
much longer. The major reason of this was the lack of finance.
Nation-wide databases (e.g. tax office records) were also used to perform a variety of
statistical tests. Some observers tried to find evidence on superior performance of foreign
companies in the Hungarian economy. An analysis using a wide range of financial, export and
investment indicators in order to compare the performance of different ownership groups did
not find any striking difference until 1994. Foreign firms productivity was higher than
average, but their gross profits lower and they produced negative net profits. Productivity gap
continued to increase over time. This finding together with the case study evidence on higher
wages paid by foreign employers clearly reflect a strong productivity position of foreign
firms. They cream the labour market employing the best quality for higher salaries, but they
achieve an extraordinary high level of output using this labour, that compensates for above
average wages.
More recent surveys of corporate performance proved that the productivity gap between
domestic and foreign firms that started to widen in 1995 continued to do so until at least
1998. The productivity gap was paralleled by profitability gap too, starting in 1996. The main
component of superior productivity and profitability remained labour productivity. For
example, the share of wages in total costs increased by 2,5 % from 1997 to 1999 in the
Hungarian economy as a whole. In the case of majority owned foreign firms a 1,2 % decline
in the same measure was observed. Foreign firms also started to realize profits, moreover, due
to the favorable tax conditions many foreign companies allocated much of their global profits
to Hungary.
The relatively high wages paid by foreign companies may deteriorate competitive positions of
less powerful local firms. The problem is exacerbated by the very high labour taxes. In fact,
for every unit wage paid to an employee, approximately two units of different taxes and
contributions have to be paid to the state. The two most commonly used methods to overcome
this problem are to pay out salaries as contract payments to “quasi entrepreneurs”, and
underreporting both turnover and employment costs.
There is some consensus among scholars that the widening of the productivity and
profitability gap started to decelerate by the late 1990s. For example in the case of capitaland total productivity measures there was no worsening as regards Hungarian owned firms’
relative position is compared to foreign firms. Still, it is too early to speak about some kind of
convergence. In the light of the similarity of measures taken during the early and late 1990s
one can put the question how strong was the influence of large free-trade-zone-based
assemblers activity in the period of the mid 1990s with the rapidly widening productivity and
profitability gap was registered? In some measures there is a huge jump e.g. when IBM
Storage Products started operation in 1996. Obviously, the accelerating divergence was
strongly influenced by the massive entry of high productivity assemblers on the Hungarian
markets.
Points of discussion are clear again. Is the productivity gap another sign of foreign
isolation? Is the widening of the gap a further negative spillover effect coming from the
foreign sector (a result of increasing competition)? Or there is rather a positive spillover
effect, and domestic firms can narrow the gap on the long run?
Impact on R&D
Besides measures of productivity, it is the transfer of knowledge and technology, as well as
the development of R&D activity that received the most interest among potential spillover
effects. Opinions vary from the emphasis of devastating effects to optimistic views. The
statistical figures indicate that there has been a steep decline in R&D spending during the
1990s in Hungary. Both state – university and industry sponsorship declined drastically. The
overall level of expenditure was a mere 0,5 % of GDP in 1998, compared to 2,3 % in 1988.
Strong critics of FDI argued that the new type of integration of Central and Eastern
European companies requires the complete elimination of R&D activity. Labouratories
have to be shut down, experts fired. R&D is performed at corporate headquarters and not at
local affiliates. The early empirical evidence already cleared that this opinion was not fully
justified. There was reduction but also a change in the role of maintained R&D activity of
firms in transition economies. The former widespread inefficient R&D structure was reduced
to a few areas. Also, basic research was usually replaced by more product development.
However, this process was commented as integrating subsidiaries into global R&D
networks at a level “below their technological capability threshold”. The question
emerges: what is better: being securely integrated at a low level of sophistication, or
being potentially able as an independent firm to run a fully fledged corporate activity
with R&D, and production of the full range of products, but remaining inefficient and
losing markets?
Statistical figures indicated that foreign firms spent 45 % of total industrial R&D in 1997, and
the share was increasing. R&D intensity of foreigners was much higher than of the
domestic companies. A series of companies moved R&D capacities from abroad to Hungary
(for example: Audi, Nokia, Philips, Siemens, GE, Knorr Bremse, ABB, Ericsson). There are
even firms in Hungary that have no production facility just an R&D center (for example
Japanese Tateyama). Moreover, among the most active in R&D firms there are also
assemblers. We can differentiate between two periods in FIE behavior towards local R&D.
The first “acquaintance” period was spent with the takeover or establishment of capacities, as
well as with the first confrontation with R&D potentials in Hungary. The second period that
started in the mid 1990s was characterized by starting usage of the capacities (“feeling at
home”).
The level and efficiency of technology transfer, the strong absorption capacity of Central
European countries, is based on the inherited high level of human capital. It was the good
performance of local technical staff that raised the interest of multinationals in local R&D
potential. Foreign firms themselves actively participate in human resource development.
Besides training of staff many of them have active contacts with universities. Interlinking
foreign companies, domestic firms, and universities in order to improve R&D capacities is an
important program of industrial policy of the Hungarian government. Direct
beneficiaries of the programs are usually foreigners.
The technology level of Hungarian manufacturing undoubtedly increased after the transition.
The most important component of investment in 1998 statistics was still “imported
machinery”. Foreign companies purchased 81 % of all imported machinery and equipment:
thus being the major engine of the spread of modern technology. A government survey found
that the level of technology is higher and machinery and equipment was better if: a, the
company size was larger, b, the firm had foreign owner, c, the firm was in certain sectors like
telecommunication, innovative segment of engineering industry. Domestic firms, most
notably suppliers of foreigners also benefit from technology spillovers. All major empirical
contributions reported such effects. This is in fact a necessity if regular cooperation is to be
maintained.
Investment Policy Audit
Legal and fiscal conditions of entry into Hungary
The current regulation of companies' establishment was based until 1998 on the 1988
Company Law. This Law created and prescribed the basic structures and functions of
partnerships and corporations. Conditions and legal requirements of the establishment and
closure of companies were also regulated. The Law itself was a mixture of elements from
German and Anglo-Saxon legal traditions. This special character was perhaps best illustrated
by the complicated governance structure that involves a Board of Directors and a Supervisory
Board as well. Legal and regulatory conditions of entry were in accordance with international
practice. The new 1998 Company Law did not change much the conditions of entry.
Conditions for establishing economic associations
Establishing business organisations consists of several legal steps, firstly writing the articles
of association. Associations come into existence when they are entered in the companies
register, with retroactive effect, from the date of the conclusion of the articles of association.
For most association forms, differences from general rules are allowed, unless the law
otherwise stipulates. However in the case of share company, changes could be made only if
the Act definitely allow them. The business organisation shall apply for registration, 30 days
after its establishment and this is evaluated by the registration court.
Court registration is usually not considered as a major barrier to entry, since entities may start
operations (make binding legal actions) when the association agreement is signed. However,
there are a few transactions where court registration is required, e.g. for public tenders and
bank loans. But since most new ventures are small and not competitive for large-scale
government tenders this is not perceived as a problem. Also, banks require track record and
are not very active in supporting new, and therefore risky ventures.
The slow pace of registration is perceived as a problem for bigger companies, more active in
the above activities. Since court registers continue to be overloaded registration may still take
several months, especially in case the applications are not complete or valid. There are several
known cases when big business exercised strong pressure on courts and judges in order to get
exceptional treatment. Bribes are naturally not confessed, but the use of pressure from
political, governmental spheres is not rare. The situation improved during the past 3-4 years,
when the information system of the courts was substantially developed.
Conditions of operation, licence on activities, qualifications.
There are many activities which require a permit from the authorities, e.g. the establishment of
bank or insurance enterprise requires a permit from the state insurance and bank supervisory
board; establishing an enterprise in a customs free zone needs the licence of the foreign
exchange authority.
Economic Associations, within 15 days after their establishment, are obliged to notify the
authorised county social security institution to obtain a social security registration number,
which should be used in all social security matters. A firm or entrepreneur also needs a tax
registration number and a statistical number. Getting the licences, registration at the tax office,
social security and statistical office was not regarded as a problem for new business start-ups,
since these actions were usually finished the same day when the applications were submitted.
The process was even further eased, when the receipt of the three registration numbers (tax,
social security and statistical) was concentrated into one place: the tax office.
A financial index number is also needed to open a bank account. The necessary precondition
of the registration is that the portion of the base capital defined by Companies act shall be
paid into the bank account. This amount was fairly low during the initial years of transition in
order to promote private business establishments. The new 1998 Company Law increased the
minimum capital requirement for economic associations. Share companies' minimum capital
requirement was increased to HUF20mn (USD80.000) from the former HUF10mn. This
increase is more ore less a compensation for 10 years’ inflation. In the case of limited liability
companies the required capital was increased from HUF1mn to HUF3mn (USD 12.000).
These amounts are not regarded as a strong barrier.
Acquisition of Real Estate by Foreigners
In many instances the local authorities exercise discretion in respect of granting the
permission required for a foreigner to acquire real estate. Because of this possible
uncertainties surrounding granting such permission it is possible that foreign persons will
continue to establish Hungarian companies to act as the real estate purchaser. Although in
practice the establishment of a company adds several thousand dollars to the effective
purchase price of the real estate, it may be a strategy chosen by foreign person who are ensure
of the manner in which the local authority’s discretionary powers will be exercised.
Generally, a foreign person is not entitled to acquire property classified as agricultural land or
as an area under environmental protection. Agricultural land is registered as arable land,
vineyard, an orchard garden, or a forest.
A foreign person may become the owner of other types of property in Hungary only with the
permission of the chief officer of the administrative office of the municipality or district
having jurisdiction over the area in which the property is located. If the property to be
acquired by a foreign person includes a construction which is classified as an historic
building, the authority having supervisory jurisdiction over such construction must also be
involved in the approval procedure.
Registration Procedure
The most important task of registration court is to keep the data in the companies register up
to date, and to secure the quick availability of information concerning to the firms. Due to the
increasing number of applications and continuous pressure for being up to date, registration
courts were facing increasing difficulties during 1991-1994. From 1995 the increase of
establishing economic association slowed down.
In addition to the great number of cases to be settled, the other reason for slow administration
was that there was not a unified and edited set of regulations concerning to obtaining
necessary licenses for starting the enterprise’s work. There were only very few cases when
registration was completed without ordering additional data. This was improved by the new
Company Law that contains a list of documents required for registration.
In many cases, the entrepreneur wishes to be a founding member of an association with real
estate but he is not able to provide the ownership card as registration of ownership change is a
very time consuming task. But if the economic association cannot provide the ownership
certificate within a reasonable period of time, then the registration cannot take place.
Recently, the real estate register offers quick treatment for special extra fee.
The next problem is, that since the establishment of a legal entity requires registration, ant\y
changes need to be entered in the companies register, e.g. if an executive of a limited
company changes, this needs to be registered before the company can establish another
economic association. The registration of the new economic unit is delayed by the time taken
for the registration of a change in the founding member.
The duration of registration process also becomes longer due to ever-changing legal
regulations. This makes difficult the conditions of enterprises wishing to enter into agreement
with an enterprise under registration, since an enterprise under registration may start its
activity right after concluding articles of association. This means quite significant risk for
normal economic operations, due to the different scope of liabilities before and after
registration.
We should remark here, that the time necessary for registration became shorter since 1999.
But establishing a new enterprise may require a significant amount of money, due to the
“cartel” price of lawyers. Establishing a limited partnership may consume about HUF 30.000
(USD 200), while founding a limited company may require HUF 100.000 (USD 650). Since
these two economic association forms are the most popular among entrepreneurs, we can
calculate that in Hungary the establishment a small firm requires HUF 30.000-100.000, on
average.
Another problem worth considering is connected with the catastrophic conditions of real
estate registers. In Budapest, registering real estate may take 2-5 years. Since financial
institutions consider assets when making loans, the real estate cannot act as collateral for a
company if it is not registered. In a real market economy, banks tend to consider rather the
purpose of credit, than the collateral, but this is not the case in Hungary. This means that small
firms may get credit with more difficulty than big enterprises, which could be considered to
be another serious entry barrier.
Table 6.11.Basic information on different entrepreneurial forms
Unlimited
partnership
Minimal number 2
of members
Liability
members
Minimal capital
of unlimited
universal
Limited
partnership
Limited liability Share company
Company
1 full partner
may be 1
may be 1
1 silent partner
and Unlimited for the limited up to the in accordance with
insider
value of business the
possessed
share
shares
Limited up to the
contribution in the
case
of
the
outsider
According to the According to the HUF 3 million
decision of the decision of the
members
members
HUF 20 million
Minimal
cash No
obligatory No
obligatory Not less than 30% 30%
of
base
share of the capital regulation
regulation
of base capital and capital, but at least
HUF 500000
HUF 5 million
Fiscal Regime for Foreign Investors
Business establishment and joint ventures were strongly supported during the early period of
transition in Hungary. Companies which were established before 1992 obtained an automatic
tax holiday from corporate profit tax for two years. Joint ventures and foreign-owned
companies received a five-year holiday from corporate income if they operated in some key
business areas, 50 % exemption in other businesses. The special treatment of joint ventures
and foreign firms was limited after 1994, since foreign capital inflow did not seem to be very
much dependent on tax holidays, and their special treatment was considered as a violation of
the principle of equal treatment of economic agents. In fact, Hungarian producers put the
Government under pressure not to remove artificial cost advantages for their foreign
competitors. Thus, supportive tax exemptions remained intact only in certain strategic
industrial branches where modrnization, the introduction of up-to-date technologies are
required. Also, large strategic investments of foreign firms are currently more supported
indirectly, through in-kind contributions, free infrastrucural developments for premises,
changes in customs duties, etc. Tax exemptions are also used for the promotion of exports.
Another important factor in foreign investment promotion is the easy access to premises in
customs (and tax-) free areas. Such areas can be created by the companies themselves on their
own premises provided they can phisically separate it from the surroundings. A large part of
the foreign capital in Hungary works in customs-free zones (Éltető, 1998).
Starting in 1996, investment activity and the growth of companies were promoted through a
variety of tax incentives. Accelerated depreciation schedules were introduced and profit tax
was limited for retained profits. The 1995 experience with a lower corporate tax rate was
basically a success: this year’s total corporate tax collection exceeded the expected level.
Though, the economy also received slight growth in that year, and the increment in tax
revenues was partly due to this fact. At the same time investments in the export sector in less
developed regions were also promoted by new tax holidays beginning in 1996. These
exemptions were aimed at big businesses that invested over a fairly high threshold limit,
created many new jobs and increased exports. Obviously, this new investment promotion
scheme was almost tailored to foreign investors, even if it was also available for Hungarian
firms too. Semjén (1998) clearly proved that the effective corporate income tax rate for large
companies was much lower than for small business due to the different exemptions that were
basically not available for small companies.
The government of the Young Democrats that came to power in1998 introduced a reduction
in the social security payment of employers, by 3 %. The 1999 personal income tax
calculations were also made easier: there were only 3 income categories instead of the former
5 to 6. But the widening of the tax base also continued and some deduction possibilities were
lifted. Still, there is quite a number of ways to reduce personal income tax payments. For
example investments in the stock market or in the voluntary pension funds are promoted by
considerable tax deductions (up to 50 % of the actual investment). Another 1998 innovation
of the government was that it charged the tax authority with the right and duty of social
security payments’ collection too. This step seems to be logical, since the clients of the two
institutions used to be the same. Still, the social security database was unreliable and almost
useless, thus the tax authority had to invest rather heavily in updating its information network
and in brushing up the social security database. The efficiency of tax collection may further
improve due to these efforts.
As far as potential bribes are considered we may expect the existence of bribes in the tax
system, since a few scandalous cases reach the public through the media and perhaps
numerous smaller cases also happen. The problem is really, that politicians as well as state
officials seem to have at least indirect links to corruption. Therefore the elimination of the
problem is extremely difficult. But bribes and corruption is more typical for big business and
does not necessarily mean a real possibility of jumping certain barriers to entry for small
businesses.
Semjén-Tóth (1998) collected information about potential violations of the tax law. Their
estimation was based on a survey that used the randomised response technique. They found in
1998 that 8.8 % of the interviewed firms did cheat with taxes (mostly underreporting real
sales turnover), with +/- 14 % variation at 95 % confidence level. This means that the real
share of affected companies should be somewhere between 0 and 22.8 %. The same analysis
was carried out in 1994 when the results were significantly worse. They found 35.8 % +/- 15
% at 95 % confidence level meaning that at least 20 % of the interviewed firms cheated
already at least once. The reasons of this decline in their opinion may be the introduction of
lower corporate income tax, the improvement of the business climate and increasing growth
potential, as well as the more effective tax collection practice (an increase of the risk of
getting caught and fined).
State’s Role in Investment Policy
Creation of local supplier networks
Most multinationals operate global networks, thus, linking multinational companies with local
suppliers means linking local firms into a highly competitive structure. Global networks are
not arms-length business contacts. The networks require competitive values from suppliers
(adequate technology, reliability, high quality, flexibility, matching communication systems,
etc.). These values may be present or can be developed: the chances of absorption are very
different in each firm. It depends on the assets and existing qualities of the firm, the economic
environment, the role and tasks a potential supplier would fulfill in the network and the
willingness of networking partners to support. On the other hand, being member of a
cooperating network means long term commitments of all parties, which also includes certain
level of technology cooperation and continuous knowledge transfer, and adequate level
of profits. Network membership also serves as a reference for firms enabling them to widen
cooperation or to make new contacts.
Supplier links of foreign companies started to develop as soon as they took up operations in
Hungary. Thus, their interest in developing local roots was already clear. The empirical
evidence showed that some foreign firms outsourced only a few services, meanwhile others
tried to outsource as much of the production as they could. A comparison of Suzuki and GMOpel for example showed that substantial local delivery was beneficial for both FIE and local
suppliers, if the production surpassed a minimal volume. GM car production of 15.000 pieces
a year was below the threshold: it was not economical to start producing components for this
car in Hungary. Thus, besides some auxiliary services, only the accumulator and the motor oil
were sourced in Hungary. At the same time, because of local content requirements, and the
absence of Suzuki’s traditional background industry, this firm actively looked for local
suppliers. This activity was supported by the Hungarian government as well.
Foreign firms’ possibilities to use local supplies very much depends on their status in the
global network. Local affiliates of huge multinationals may play a rather marginal role, or
their role, the scope and nature of their activity may change over time. In certain periods local
affiliates may perform very simple subcontracting-type activities, like assembly, or simple
labour-intensive processing. These activities do not provide much room for local suppliers.
Through further investments the activities can be developed towards more added value and
sophistication, but this can be influenced primarily by FDI and investment policy, and not by
linkage promotion. Estimations on Hungarian supplies to some important TNC affiliates show
very different pictures:
TNC
SONY
Opel cars
Audi
Philips
Suzuki
United Technologies Automotive
GM
Ford
Electrolux
Opel gear production
RÁBA
GE-Tungsram
% Hungarian supplies
(estimated)
<5%
7%
< 10 %
Appx. 10 %
Appx. 10 %
Appx. 10 %
10-20 %
> 20 %
40-50 %
40-45 %
40-45 %
60-70 %
State assistance of supplier network establishment
The Hungarian government launched the Supplier Target Program 1998 to promote the most
promising way of increasing FDI spillover effects, by establishing local supplier ties. After
two years of operation, some basic principles of the program were reconsidered and the
program was relaunched in 2000. The basic idea of the Program was to support potential
local suppliers with technical and financial help to improve their technical, financial and
knowledge background. An adequate level of technological sophistication, quality control,
communication systems and reliable delivery were regarded as preconditions for becoming a
supplier of multinational firms. Most Hungarian small and medium sized companies (SMEs)
did not qualify without some kind of help.
The Supplier Target Program (STP) recognized this SME development need. It aimed at the
creation of direct links by helping matchmaking and contracting between foreign and
Hungarian firms in selected industries: automobile, electronics and rubber and plastics. In
doing so it focused on providing information and contacts, as well as training and consulting
to potential SME suppliers. Hungarian firms, especially SMEs were set in the centre of the
program. The program was not really successful, because it did not count with two
circumstances:
a. That foreign companies had various interests;
b. There were Hungarian mediators (first tier suppliers) already on the market.
Match-making between Hungarian SMEs and multinational affiliates proved to be very
difficult.
The Supplier Target Program was reconsidered in 2000, and the new Integrator Supplier
Target Program (ISTP) was launched the same year. The basic idea of the new Program is
that existing supplier networks can be further developed as a nucleus of a bigger and
more colorful cooperation network, a local cluster. It changed the direction of the
promotion activity: it starts with the needs and requirements of foreign firms and other
integrator firms. The primary purpose of the program is to increase local supplies’ share
from the current 10-20 % to 30-40 %. Matchmaking events are continuously organized, and
there are plans to update the established database and even expand it to 4000-5000 records.
Training and advising of domestic companies remained on the agenda, qualification and
auditing of supplier members of the program is also foreseen (with financial support from the
program sources). Long-term finance for necessary investments in supplier firms is also
planned by the new Program. This would include both loans and equity participation (venture
capital). Support of quality insurance programs also remained in place. The new state support
agency regularly monitors the system and keeps continuous contact with the participants.
There are, however some problems with the new projects too. The most serious problem is
perhaps the role of the state as venture capitalist. RDC and other state-owned “venture
capital firms” were created in fact for crisis management and not for risk management. The
new role may cause problems for them. Unfortunately, there are very few private venture
capital firms in the region, the state companies serve as a second best solution in the crisis
management function as well. It is also a question whether the new type of local agency, the
Supplier Agency, will be much different, more active or efficient than its predecessor. It is
maybe not fair to ask a new institution to try to cope with all kinds of development
preferences. Maybe regional development issues should not be incorporated in this
framework. But it is almost certain, that the new institution will further increase spatial
tensions in the country. It supports the development of clusters in the places where they
actually are: the relatively most developed parts of Hungary.
Annex 1.
% share of different industries in gross output, 2000
Agriculture, forestry, fishing
4,9
Mining and quarrying
0,2
Manufacturing
38,6
Food, beverages and tobacco
5,8
Textile and textile products
1,3
Leather and leather products
0,3
Wood and wood products
0,4
Pulp, paper and paper products, publishing and printing
1,6
Coke, refined petroleum products and nuclear fuel
2,4
Chemicals, chemical products and man-made fibres
2,7
Rubber and plastic products
1,3
Other non-metallic mineral products
1,2
Basic metals and fabricated metal products
3,1
Machinery and equipment
1,6
Electrical and optical equipment
10,4
Transport equipment
5,9
Manufacturing n.e.c.
0,5
Electricity, gas, steam and water supply
3,5
Construction
4,4
Trade and repair
9,0
Hotels and restaurants
1,4
Transport, storage and communication
6,8
Financial intermediation
2,7
Real estate, renting and business services
10,0
Public administration and defence, social security
3,9
Education
2,4
Health care
2,8
Other community, social and personal services
2,5
Source: CSO